GARCH and ECM Approaches to Detecting Economic and Financial Volatility: Evidence from Indonesia

Abstract

This study investigates the dynamic relationship and volatility effects of macroeconomic fundamentals and financial indicators on Indonesia’s capital market using a dual econometric approach: the Generalized Autoregressive Conditional Heteroskedasticity (GARCH) model and the Error Correction Model (ECM). The research focuses on key macroeconomic variables—namely inflation, interest rates, exchange rates, and money supply and their impact on financial indicators including the Composite Stock Price Index (IHSG) and the stock prices of Indonesia’s most active listed companies: PT Aneka Tambang Tbk (ANTM), PT Adaro Energy Tbk (ADRO), PT Bank Rakyat Indonesia Tbk (BBRI), PT Telekomunikasi Indonesia Tbk (TLKM), PT Merdeka Copper Gold Tbk (MDKA), PT Bank Central Asia Tbk (BBCA), and PT Vale Indonesia Tbk (INCO). Utilizing monthly time series data and applying the GARCH model, this study measures the volatility clustering and persistence of shocks in both individual stock prices and IHSG. The ECM is then employed to examine the short-term dynamics and long-term equilibrium relationships between economic fundamentals and financial indicators. The empirical findings indicate that exchange rates and interest rates have significant volatility effects, while money supply and inflation exhibit varying degrees of influence depending on the sector. The integration of GARCH and ECM models provides comprehensive insights into market stability and the responsiveness of stock prices to macroeconomic shifts. The study contributes to portfolio risk management, monetary policy formulation, and corporate financial planning in emerging markets.

Keywords

GARCH; ECM; Macroeconomic Volatility; Stock Market; Indonesia; Inflation; Interest Rate; Exchange Rate; Money Supply; IHSG